Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. As with many other companies Xuchang Yuandong Drive Shaft Co.Ltd (SZSE:002406) makes use of debt. But the real question is whether this debt is making the company risky.

When Is Debt Dangerous?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.

What Is Xuchang Yuandong Drive ShaftLtd's Net Debt?

You can click the graphic below for the historical numbers, but it shows that Xuchang Yuandong Drive ShaftLtd had CN¥15.5m of debt in September 2024, down from CN¥300.0m, one year before. However, it does have CN¥1.21b in cash offsetting this, leading to net cash of CN¥1.20b.

A Look At Xuchang Yuandong Drive ShaftLtd's Liabilities

The latest balance sheet data shows that Xuchang Yuandong Drive ShaftLtd had liabilities of CN¥629.2m due within a year, and liabilities of CN¥170.4m falling due after that. Offsetting these obligations, it had cash of CN¥1.21b as well as receivables valued at CN¥829.9m due within 12 months. So it actually has CN¥1.24b more liquid assets than total liabilities.

This excess liquidity suggests that Xuchang Yuandong Drive ShaftLtd is taking a careful approach to debt. Because it has plenty of assets, it is unlikely to have trouble with its lenders. Simply put, the fact that Xuchang Yuandong Drive ShaftLtd has more cash than debt is arguably a good indication that it can manage its debt safely.

Also good is that Xuchang Yuandong Drive ShaftLtd grew its EBIT at 19% over the last year, further increasing its ability to manage debt. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Xuchang Yuandong Drive ShaftLtd will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. While Xuchang Yuandong Drive ShaftLtd has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. Over the most recent three years, Xuchang Yuandong Drive ShaftLtd recorded free cash flow worth 57% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.

Summing Up

While it is always sensible to investigate a company's debt, in this case Xuchang Yuandong Drive ShaftLtd has CN¥1.20b in net cash and a decent-looking balance sheet. And it impressed us with its EBIT growth of 19% over the last year. So we don't think Xuchang Yuandong Drive ShaftLtd's use of debt is risky. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. For instance, we've identified 3 warning signs for Xuchang Yuandong Drive ShaftLtd (1 is significant) you should be aware of.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.